A couple of terms that young investors beginning to save for retirement should learn are compounding and expense ratios.
One lesson that wecan learn by analyzing market returns are the benefits of long term investing and of investing on a regular basis according to a disciplined plan. Even a relatively small amount of money can grow exponentially given a decent return and enough time. Young people just entering the workforce should take advantage of their employer sponsored plan if they have one. If not they should start saving into an individual retirement account like a traditional IRA or a RothIRA.
When selecting an investment vehicle to start with, consider expenses and diversification. A good starting point for most younger people would be a low-cost index fund. For example, an index fund modeled on the Standard & Poor’s 500 Index will give you exposure to the 500 largest companies in the U.S. As your retirement account grows, additional index funds can be added to provide further diversification. International index funds and small-cap funds can provide more diversification.
To help understand the effects of compounding and the importance of expenses, let’s calculate some hypothetical returns. The S&P500 has returned an average of about 11% for the last 30-year period and the last 40-year period. Say you’re 25-years-old and just getting started on your retirement plan. If you were to put $1,200 a year into the S&P 500 and the S&P were to return 11% like it has for the last 40 years, you’d have accumulated almost $775,000 by the time you reach age 65. For a 30-year period with the same contribution you’d reach about $265,000. Twenty years would get you to $85,000 and in 10 years you’d have saved just over$22,000. Keep in mind that it is not possible to invest directly in an index; you have to use a low-cost index fund. The expense ratio for an index fund is very low, less than 20 basis points or 0.20%, but that should still be factored in.
Also, keep in mind that even though the S&P 500 has returned over 11% annualized for those long time frames, it hasn’t done as well recently. In the last 20 years, the index increased just over 9% and the most recent 10 year period is a little above 7%. I’m using round numbers here for the sake of illustration.
If we use a return number more in line with the last few years, like 8%, we’ll get the following results, using the same annual contribution, $1,200; in 10 years you get about $18,000, 20 years about $59,000, 30 years about $146,000 and in 40 years you’d reach $335,000.Those calculations really show the importance of time and why you should get started as early as possible. Notice the difference between the 30-year number and the 40-year number, your account would more than double in the final 10-year period.
Here’s an example of why investment expenses are so important over the long haul. Let’s compare the 8% number assumed above to a 7% return, a difference that may seem trivial, but let’s consider the effects over a long time frame. Once again we’ll contribute $1,200 a year without increasing the contribution. In 10 years we get to $17,000, 20 years $52,000, 30 years $121,000 and over 40 years it grows to $256,000. Just a one percentage point difference gives you $79,000 more at age 65 without ever increasing the $1,200 a year contribution.
Remember start saving early and save often.
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View more information: https://www.marketwatch.com/story/why-you-should-save-early-and-save-often-2014-07-17